Entity Formation

Choosing how a business is organized may be one of the most important decisions a business makes. Incorporation may be the wisest decision, but for some, it may be an unnecessary decision, and so each business should carefully assess the benefits (and challenges) of incorporation before moving forward.

With that said, the greatest benefits to incorporation can be summarized into the 3Ls: Life, Liquidity, and Liability.

So let's start with Life.

Life

The best way to understand a corporation is to imagine it as a separate artificial person (with limited rights and privileges). Incorporating a business is essentially creating that separate person thereby making the business separate from the owner (in a sense, the business has a life of its own).

As a separate entity, the corporation exists independent from the shareholders/owners and its employees. Regardless of what happens to the shareholders, or the directors, or the employees, the corporation itself continues to exist in perpetuity until a time the directors and shareholders decide to dissolve a corporation.

In a sole proprietorship or general partnership where the owner(s) is the business, what affects the owner may affect the business. Any personal debt or liability of an owner or partner allows the creditor(s) to pursue the assets of the business whether or not the debt or liability has any relation to the business itself.

Furthermore, personal bankruptcy of an owner or partner will directly impact a business by opening up its assets to any creditors the owner or partner is liable to. By incorporating a business, the personal finances of an owner or partner remains separate from the finances of the corporation and allows the business to continue without disruption.

In the event of an unfortunate death of an owner or partner, the business is generally dissolved regardless of the wishes of the owner or partner(s). All of this could easily be avoided by incorporating the business as a separate entity.

Liquidity

As much as we believe that all owners of a business should remain forever committed to the success of the business, there may be times when an owner or partner will need to leave the business.

Regardless of the reasons for leaving the business, incorporation allows the free transferability of interest from one person to another.

Generally in a partnership, a partner cannot transfer his/her interest in a business to another without the express consent of all other partners. If a partner still decides to leave the partnership against the will of the other partners, the partnership is automatically dissolved.

Incorporating a business removes this limitation by allowing shareholders/owners to freely transfer his/her interest to another without the unanimous consent of all other shareholders. Small businesses may see the restrictions against transferring shares as a good thing and may want to control how a shareholder may transfer his/her interest and to whom. Incorporation allows this flexibility as well.

The free transferability of shares is a default rule, but by no means is it mandatory for all incorporated businesses. Businesses have the option to place restrictions on the transferability of certain shares and so even if this benefit of liquidity may be seen as a detriment to a business, incorporation lets the business decide whether or not to take advantage of this option.

More importantly, unlike a partnership, incorporation prevents the ability of a minority shareholder from dissolving a business without cause.

Liability

One of the greatest benefits for incorporation is its limited liability against the shareholders.

As mentioned above, any debt or liability against a specific shareholder remains separate from the corporation.

Likewise, the inverse is similarly true. Any debt or liability against a corporation does not open the doors of shareholders' assets to the creditor(s). The shareholder's liability in any corporate debt or liability is limited to what the shareholder invested (unless there is fraud).

In a sole proprietorship or general partnership, the owner(s) and/or general partners remain completely liable to any debt or liability placed against the business. If a business is unable to pay a debt, the creditor can attack the assets of an owner or partner until the debt is satisfied.

In a corporation, a creditor can only attack to the extent the shareholder invested into the corporation (unless there is fraud). This allows the corporation to make business decisions without the risk of endangering the personal assets of its shareholders beyond what was invested.

Risk is a necessary element to a successful business. Anything that minimizes the risk to investors makes the business more attractive, and so the limited liability of an incorporated business is quite valuable.

Taxes

The major detriment to incorporation is the taxes involved. In a sole proprietorship or partnership, the taxable income of the business flows directly to the owner and/or partners and are taxed based upon the individual's income tax bracket.

However, because the corporation is considered a separate entity, the taxable income of a corporation is taxed first under a corporate tax. If the corporation decides to distribute the remaining income to the shareholders, that income is taxed once more based upon the individual's income tax bracket (essentially, a double-taxation).

The marginal tax rate for a corporation can be significantly higher than the marginal tax rate for a sole proprietorship.

lthough this characteristic of incorporation may deter a business from incorporating, small businesses can avoid this double-taxation by taking advantage of the options given to a corporation by the states.

Some options include incorporating as an S-corporation (see below) or filing as a Limited Liability Company (LLC) (see below).

These options allow the taxable income to flow directly to the shareholders/members without being taxed twice, while at the same time, maintaining the benefits of incorporation.

The 3Ls are important benefits, but not the only benefits. There's also something psychologically beneficial about incorporating that goes beyond the number crunching and legal issues involved.

Incorporation may seem to be a daunting task, but it is also an exciting moment in the life of a business. First conceived through an idea, a business can be birthed at the point of incorporation. No longer will it simply be an idea or something intangible, but an actual and existing entity. Sometimes this psychological step of seeing the business as something real will further motivate and inspire you to bring greater success to your business.

Reduced Chance of Tax Audit

Sole proprietors tend to be more likely to file incorrect returns (many are self-prepared), and tend to under report revenue or over report deductions.

For these reasons, the IRS has audited a much higher percentage of sole proprietor tax filings than corporate filings in recent years.

In tax year 2006, a Schedule C filer stood a 1 in 32 chance of being audited. For non-business filers, the odds were around 1 in 124. This means that sole proprietors are significantly more likely to be audited.

Build Credibility

Distinguishing yourself from the competition by establishing a professional identity helps increase credibility with your customers.

Most businesses choose to incorporate a business to prove their legitimacy to both customers and suppliers. Adding "INC." or "LLC" after your business name gives you the credibility and professionalism that many customers are looking for.

You could file all the necessary incorporation documents yourself. However, when you consider the time involved for filing, administering, and maintaining all the documents necessary to keep your business running legitimately... why would you?